Are These Unique Circumstances or a Changing Asset Class?
- by Brandon Michaels & Chris Adnams
As interest rates for commercial real estate remain elevated, a flood of notable debt defaults, special servicing transfers, and loan losses specific to the office sector have made headlines:
Feb/April 2023 – Brookfield’s $784 million debt default on a pair of 52-story office towers in DTLA in addition to a default on $161 million debt encumbering a portfolio consisting of twelve smaller office properties in Washington D.C., Florida, and Georgia
Feb 2023 – 19-Story Houston, TX suburban office property, Three Westlake Park, liquidated with a loss of $67.4 million or a severity of 88%
Feb 2023 – PIMCO’s Columbia Property Trust defaults on $1.7 billion of debt encumbering seven office buildings in New York City, San Francisco, Boston, and Jersey City
April 2023 – Tishman Speyer requests special servicing on the $485 million debt on its New York City Park Ave office building in advance of upcoming maturity date
April 2023 – Liquidation of the $9 million loan encumbering the Piedmont Center in Greenville, SC realizes losses of $6 million, a 66% severity
April 2023 – Workspace Property Trust’s $1.27 billion loan portfolio backing 146 suburban office properties split amongst Minnesota, Arizona, Florida, and Pennsylvania transfers to special servicing ahead of maturity in July
Is the office sector facing temporary challenges or is this a shift in fundamentals and behavior patterns that will prove detrimental for the sector?
What is Special Servicing & Why is it Significant?
CMBS loans are pooled together with a diverse selection of other mortgage loans, placed into a Real Estate Mortgage Investment Conduit (REMIC) trust, and then sold to investors. When these individual debt obligations go into distress in which the borrower defaults on payments, servicing of the underlying loan is transferred to a special servicer. The goal of special servicing is to provide specific relief and loan modifications to bring a CBMS note back into compliance or to handle the foreclosure and subsequent sale of the property (usually at a discount).
As of April of 2023, special servicing accounted for 5.62% of all CBMS debt according to recent Trepp data. That’s up 65 basis points from a report six months earlier in October of 2022 and is the seventh consecutive monthly increase. The significant contributor to this increase comes from the office sector, which experienced a more than 167 basis point increase in special servicing transfers in the last 6 months. In the month of April alone, the office sector experienced just under $1.5 billion worth of special servicing transfers, a sign of a deeply troubled asset class.
The Drivers
In a review of the most recent notable office debt defaults, two recurring drivers stand out: rising vacancy rates and variable interest rate loans. After a period of historically low interest rates beginning in early 2020 and running through the end of 2021, landlords are now faced with some of the highest interest rates and tightest lending conditions since the Great Financial Crisis of 2008.
Two of the most common indices used to underwrite adjustable-rate loans, the WSJ PRIME and 1-month SOFR rate, are up 450 and 475 basis points, respectively, since the beginning of 2022, putting a strain on the ability to meet the obligations of rising adjustable interest rate loans and refinance requirements as debt is coming due. In Brookfield’s February debt default, representatives cited skyrocketing monthly debt payments brought on by rising interest rates as the cause of default.
The challenges of adjustable mortgage rates and higher interest rates overall are only half of the equation. For some, increasing vacancies have hurt cash flow even more. Tishman Speyer’s $485 million debt on its New York City Park Avenue office building reported occupancy of 84%, down from 99% before the pandemic, reducing year over year cash flow by 22%, with an additional 25% of leases expiring within a year. Furthermore, Brookfield’s April default on its 12-office property portfolio was triggered by an even larger decline in occupancy, from 78.9% at origination to 52% when it was last reported in 2022. Across all major office metros, vacancies have risen sharply since the start of COVID-19 as businesses reassess their need for office space.
Signs of a Potential Recovery
Just as weakness in the office market begins to materialize through defaults and special servicing transfers, there may be signs of life for the asset class. While interest rates show no sign of letting up, new data from VTS’s Office Demand Index (VODI) showed a 31% increase in demand for office space nationally from February to March. Furthermore, a growing movement of major U.S. corporations including Amazon, Apple, Citigroup, Disney, and JPMorgan, to name a few, have issued statements requiring their workforce to return to the office. JPMorgan’s CEO, Jamie Dimon, noted that remote work “slows down honesty and decision making” as a consideration in the return policy. The effects of these policies can already be felt as office entry and utilization data in March showed a roughly 33% increase in attendance from the same time last year according to a survey of 2,600 office buildings across 10 major U.S. office metros conducted by Kastle Systems. This may be an indication of strengthening demand.
More Pain Ahead?
Over the past few years, office owners have been able to mask operational inefficiencies, increased vacancies, and softening rents with a lessened burden of debt, but as lending conditions tighten, the competitive advantage or disadvantage of specific assets becomes exposed. Some of these loan defaults are strategic, providing landlords runway to lease up vacancies, negotiate loan extensions, modifications, or forbearances. In other instances, landlords will be forced to hand over the keys or make a hasty sale at a discount. While these headline defaults show that the office market is already experiencing pain, much of the continued fallout will be determined by the outcomes of upcoming Federal Open Market Committee (FOMC) meetings and long-term demand for office space as businesses grapple with a post COVID-19 economy.